Welcome to financial forecasting for product managers. Welcome to the session on advanced profit and loss statement analysis and forecasting. This lesson is an advanced lesson that builds on my previous lessons: Size your market with TAM, SAM, and SOM and Understanding your financials, P&L margins, and valuation. From the courses, the business of product management 1 and 2 in the AWIT Coursera Real-World PM Specialization, sponsored by Amazon Web Services. Today, we're going to take a look at how to create credible financial forecasts, work with your colleagues in the finance department, and benchmark your accomplishments as a product manager within your organization. Jeff Bezos in Amazon's 2008 letter to shareholders wrote, "Our primary financial goal remains maximizing long term free cash flow." What is free cash flow? To simplify quite a bit, it's Amazon's money in the bank. You can think of it as the sum of net income across all of its P&Ls. Again, I'm simplifying quite a lot. The point is that with money in the bank, Amazon can continue to invest in attracting talent to work there, reinventing its existing businesses, and starting up new businesses in new market spaces. As a product manager in charge of product direction and pricing, you should also be able to articulate the impact of your product on Amazon's free cash flow. You do so by creating a financial forecast like this. One, create a credible P&L forecast. When you're the product manager for a new product, you create a financial forecast. Let's take an example product, suppose that you're in charge of a purely fictional product, Amazon vehicles. Amazon vehicles allows customers to buy a car. Again, I want to emphasize that Amazon vehicles is completely fictional and does not exist. How do you forecast your P&L? Well, the first step is to document, research, and debate the assumptions that underlie your P&L with everyone on your team, related teams, your customers, and anyone else you think might be helpful and can speak to you under a non-disclosure agreement or NDA. The process is very similar to market sizing with TAM, SAM, and SOM. You should calculate the total addressable market of how much people spend buying and renting cars, the serviceable available market of people who can access the Amazon vehicles MVP, and the service obtainable market of people who actually make purchases with Amazon vehicles. Immediately, you'll run into a number of questions. How is Amazon going to get cars? Will it have an inventory of cars it buys at auction? If so, what is the expected profit margin after Amazon's expenses, such as purchasing, storing, and shipping the cars? Or will you rely entirely on third party sellers such as car dealerships to supply the cars? If so, what profit margin will the dealerships agree to? Then, as the product manager, you also have to look at your Amazon expenses. How many engineers will you need to build out the infrastructure supporting Amazon vehicles on AWS, and how much does that infrastructure cost? How many product marketing managers and business development staff do you need to promote your product to the public, and how much do they cost? How much will you have to pay in customer support? How much will you budget in refunds and credits to handle issues such as returns or buyers who complain that they never received their car? How much will you spend in advertising and where would it create the most benefit? What do you do with all these questions? You write them down in a document, then you research, writing down your assumptions, and calculating preliminary numbers for your P&L spreadsheet. Next, you debate these numbers and assumptions and reviews, and informally, with your teammates between reviews. Eventually, you'll get everyone to sign off on your answers, both your assumptions as well your numbers. The most astute among you might notice several important questions missing from what I just asked. The first is, what is the time horizon for the forecast? My advice is that you want a time horizon that is long enough to show when your product will bring in enough net income to exceed your company's internal rate of return. Which brings us to our second important question, what is my company's internal rate of return? The internal rate of return, which we often abbreviate IRR, to once again heavily simplify, is how much the company would earn if it didn't build your product and instead left its money in the bank. This is a number you should ask your finance colleagues for, if you don't already know it. The longer your product takes to build, the higher the IRR to overcome. All companies have an IRR, not just Amazon. Generally, to launch your product, your products financial forecasts should show convincingly that it exceeds your company's IRR. The third important question is, what is the sensitivity of your forecast? Remember that we're debating and signing off on assumptions and estimates. The net income from our P&L is not a point on a number line, but rather a range of possible numbers. We also want to understand how confident we are that our assumptions are correct. If we're highly confident, we have low sensitivity. We might tack on a negative five percent pessimistic assumption on the left, in a plus five percent optimistic assumption on the right. However, if we have convincing data and arguments that pull us in many directions, as you see here, we might take on a negative 20 percent on the left and a positive 15 percent optimistic assumption on the right. Sometimes you might even document different sensitivity for each line of your P&L. Most of the time you'll end up with three sets of financials: worst case, best case, and most likely. In my pricing lecture, I'll explain that some products might, for whatever reason, have no pricing. In those cases, your P&L forecast takes on even more importance, because your losses will not be offset by profits. I and other AWS leaders will evaluate how much in losses you expect to incur from both building and maintaining your product, so that we can limit our downside exposure. The fourth and final important question for you to answer is, what is the downstream impact of your product? Downstream impact, which we had Amazon abbreviate DSI, refers to the benefit or cost your product will impose on all other Amazon products. For example, maybe Amazon vehicles causes one percent of its users to sign up for Amazon Prime. That downstream impact could be huge. There are other situations where Amazon vehicles might take away customers from existing Amazon products, in which case it's possible for your DSI to be negative. As with any other assumption, you want to document, research, and debate your assumptions. Understand that as a PM, you should build products to capture direct revenue from people paying to use your product, rather than chasing indirect downstream impacts. That's because your company can only recognize each dollar of income exactly once. Subscription fees people pay Amazon Prime is Amazon Prime's revenue. The PMs at Amazon Prime get credit for bringing in that money, even if it's your product's downstream effect. Recommendation, build your product to maximize direct revenue.
